working capital definition

Chapter 6
BUSINESS CONTEXT
History of the Cash Flow Statement
The balance sheet and income statement have been required statements for years, but the
cash flow statement has only been formally required in the United States since 1988.
However, cash flow statements, in some form or another, have a long history in the
United States. In 1863, the Northern Central Railroad issued a summary of its financial
transactions that included an outline of its cash receipts and cash disbursements for the
year.
In 1971, the APB (predecessor of the FASB) started requiring that a ―funds
statement‖ be included as one of the three primary financial statements in annual reports
to shareholders. The APB did not specify a single definition or concept of funds or a
required format for the statement. The most commonly used definition of ―funds‖ was
working capital (current assets minus current liabilities). Thus, a ―funds statement‖
reported changes in cash, accounts receivable, and inventory as if they were the same
thing. The funds statement was not without its problems. Buildups in receivables and
inventory without a corresponding increase in sales would result in positive funds from
operations yet result in no cash. The W. T. Grant Company provided a classic example of
the downside of using the working capital definition of funds. The largest retailer in
America prior to its bankruptcy filing in 1975 was W. T. Grant, whose continued buildup
of inventory and receivables (resulting in positive funds from operations) masked a five-
year negative cash flow from operations that eventually led to the company’s demise.
As a result of numerous cases like W. T. Grant’s, the Financial Executives Institute
(FEI) began encouraging its members to adopt a cash emphasis in their funds statements.
In 1980, only 10 percent of the Fortune 500 companies used a cash focus; the other 90
percent reported net changes in working capital. By 1985, 70 percent used a cash focus.
In late 1987, the FASB finally called for a statement of cash flows to replace the more
general funds statement. At that time, the FASB established the statement format that we
use today, based on the three-way classification of cash flows into operating, investing,
and financing activities.
Because the required cash flow statement is relatively young (remember, double-
entry accounting is 500 years old), it sometimes doesn’t get the emphasis it deserves as
one of the three primary financial statements. In fact, because the traditional analysis
models were developed in an age when cash flow data were not available, analysts will
go to great lengths to approximate cash flow numbers, seemingly unaware that since
1988 the actual numbers have been easily available in the cash flow statement. For
example, a number often used in evaluating a company’s health is EBITDA—earnings
before interest, taxes, depreciation, and amortization. When pressed about why they use
this number, an analyst will say, ―EBITDA approximates operating cash flow.‖ Why
don’t analysts use the real cash flow numbers? Because information from the cash flow
statement is not yet ingrained in the analytical tradition. But it will be.
Questions
1. Briefly describe how using the working capital definition of funds masked the cash
flow troubles of W. T. Grant.
2. Why is the cash flow statement frequently overlooked by financial analysts?
Sources: James H. Thompson and Thomas E. Buttross, ―Return to Cash Flow,‖ The CPA
Journal, March 1988, pp. 30–40.
James A. Largay III and Clyde P. Stickney, ―Cash Flows, Ratio Analysis and the W. T.
Grant Company Bankruptcy,‖ Financial Analysts Journal, July/August 1980, pp. 51–54.
Statement of Financial Accounting Standards No. 95, ―Statement of Cash Flows,‖
Stamford: Financial Accounting Standards Board, November 1987.